Why Diageo Wants to Up its Stake in United Spirits

Yes, the news out of China is worrisome for Diageo (NYSE: DEO) . Asia Pacific sales declined an alarming 19% for the quarter ending March 31. The drop was attributed to continuing anti-corruption efforts in China, which are drying up conspicuous spending and gift-giving, as well as some challenges in Thailand due to political instability.

The good news is Diageo saw double-digit growth in India for the quarter. Now, Diageo is making another run at United Spirits. It's offering a tender of $1.9 billion to increase its ownership stake from 28.8% to nearly 55%. At 38 times EBITDA (earnings before interest, taxes, depreciation, and amortization) for the year ended March 2013, this offer dwarfs Suntory's recent offer to Beam (NYSE: BEAM) , which was around 20 times earnings.

The tender, an over 18% premium of the closing price as of April 11, left many speculating that Diageo was overpaying.

A risk worth takingIf Diageo, the largest spirits maker in the world, wants to grow then it has to expand in emerging markets. Other than China, India makes the most sense and has the most potential. Research firm IWSR valued the spirits market in India at $16.4 billion in 2012, according to Reuters. Most of the growth is occurring in the premium and super-premium categories.

India whisky rules Diageo already has the top-selling vodka (Smirnoff), the best-selling Scotch whisky (Johnnie Walker), and if its offer for United Spirits goes through it will also have the number one Indian whisky, McDowell's No.1. As of 2012, the Indian whisky was also the best-selling whisky in the world (19.5 million cases), nudging out Johnnie Walker (18.9 million cases) for the honor. McDowell sales climbed 21%, while Walker grew 5% for the year.

The top 10 selling liquors in the world move 267.6 million cases per year, and Diageo (if the deal goes through) will control 64.2 million cases, or 24% of the best-selling liquors. That's not to mention the 12th (rum-17.8 million cases), 14th (Indian whisky-14.1 million cases), 16th (Indian whisky-11.4 million cases) and 19th (Indian Brandy-10.9 million cases) ranked best-sellers. That's another 54 million cases.

By comparison, the top-selling American whiskey, Jack Daniel's, a Brown-Forman (NYSE: BF-A) (NYSE: BF-B) brand, sold 10.7 million cases in 2012.

Controlling spirits market in IndiaEuromonitor indicates United Spirits also has about 42% of the total spirits market in India (as of 2012), which also includes vodka and rum. Its closest competitor is Pernod Ricard India Pvt Ltd with 10%.

The research firm also projects the overall market will grow at a compounded annual growth rate of 7%, while single malt Scotch whisky is expected to climb at an 18% clip.

Facing risksIndia's state governments approve liquor prices yearly and companies can only raise them once each year, even if raw material costs go up.Seventy percent of liquor consumption takes place in states in which the government controls the liquor distribution network. This means that pricing power can be limited severely. It's also worth pointing out that over 60% of Indians do not drink alcohol.

A Fool's takeDiageo has to take calculated risks in emerging markets like India to grow revenues faster than consistent-but-low annual revenue increases in developed markets such as North America (1.2% for the quarter) and Western Europe (1.2% for the quarter).

Although this is a pricey one, it still makes sense long-term (five years or more). Diageo predicts that the acquisition will add to its per-share earnings by the year ending June 30, 2016.

Sure, emerging markets are more volatile and risky. With China on the ropes, though, India is the next best bet. It appears to be poised for expansion with a huge population and a growing middle class with a taste for premium and super-premium spirits. This could lead to big gains for Diageo. The wildcard is the potential for more excessive government interference.

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